BankofEnglandPossiblyGearingUpforShockRateHike

The Bank of England might raise its base borrowing costs without warning, should it consider growth, inflation and wages robust enough during its meeting on February 4.

Kristian Rouz – After a wave of turmoil hit global financial markets in early January, causing severe losses in the UK financial sector, investors rushed for safety buying out government bonds during at least the second half of the outgoing month.

Consequently, bond yields dropped, with yield on the British 2-year gilt posting its largest retreat since 2009. However, the resulting discrepancy between the currently low British benchmark 10-year gilt yield and the upbeat macroeconomic fundamentals might trigger yet another shock to the market, as Bank of England might be preparing a raise in borrowing costs sooner than expected.

The Bank of England’s (BoE) base interest rate is currently standing at its ultra-low 0.5%, almost that of the US Federal Reserve at 0.25-0.5%, yet, the oversaturation of the British financial market with investment capital is currently a far greater threat to the stability of the nation’s financial system. Select sectors traded in the City of London are hot, stirring potential bubbles, and the situation requires a raise in the base interest rate.

Yet, as UK inflation is seen as underperforming, the markets do not expect any BoE rate hikes until at least early 2017. They might be dangerously wrong.

Market sentiment is bearish on a possible rate hike, as evidenced by the dynamics of the benchmark 10-year gilt yield. The figure dropped 0.4% to 1.56% throughout January, indicating rife demand from investors rushing for safety.

Yet, the British economy accelerated in Q4 driven by consumption, suggesting a pickup in inflation, but more importantly, the UK government actually struggled to sell newly issued debt securities on an auction in mid-January. That said, the declines in yield reflect market operations with gilts maturing earlier than 2026.

"Yields at these levels are not justified by the UK economic fundamentals," John Wraith of the London-based UBS. "The market doesn't price in a rate increase until next year, and it will probably be told next week that it's priced too dovishly."

Dynamics in the 2-year gilt yield are similar in pattern, with the figure having dropped 0.31%, the most in over six years, meaning investors believe the rather slow pace of economic expansion and a still weak inflation will hardly allow the BoE to move rates higher.

The BoE, on its part, is due to announce its most recent view on policy outlook after the meeting on February 4, also releasing their understanding of GDP and inflation figures impact on the rate outlook. While the market is bearish, the regulator might not be.

One reason is that the current investment environment dictates the BoE base interest rate must be above that of the US Fed, otherwise Britain might face a massive capital flight, impairing the strength of its financial sector, effective FX rate of the sterling and the overall economic performance.

Another is, as outlined above, the hazard of potential bubbles in the financial sector amidst an abundance of capital, which can only be contained by higher rates.

The question is, would the BoE consider the performance of the UK economy and inflation in 2015 as strong enough to hike rates as soon as in the first half of 2016? If so, the shock to the market, expecting a hike in early 2017, would deal a significant blow to emerging markets and stocks in the short-term.

Previously, the BoE Governor Mark Carney said a substantial increase in real salaries would be a trigger to a rate hike. Given the massive acceleration of consumer spending in the UK in late 2015, unlike that in the US, the pickup in wages might have occurred. Eventually, the BoE might move rates without fair warning, should the actual figures support such an assumption.

In preliminary estimates, a GfK index of the UK consumer sentiment rose to its highest since August. British consumption drives 79% of domestic GDP, and quarterly growth accelerated to 0.5% in Q4, while yearly growth was 2.2% in 2015, meaning Britain performed better than most its peers among advanced economies.

Meanwhile, the recent decline of the British sterling by 7% amidst stock market turmoil and oil slump to $1.43, is another factor supporting the acceleration in inflation. Eventually, as the overall growth picked up, and real disposable incomes of the households might have increased, the BoE inflation outlook is likely subject to an upward revision. That said, the BoE rate hike might be way closer than the markets suppose.

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